A REVIEW OF THE FOREST REVENUE SYSTEM AND TAXATION OF THE FORESTRY SECTOR IN FIJI

EXECUTIVE SUMMARY

Introduction

This report presents an analysis of the economics of forest harvesting and processing in Fiji. The analysis has been used to examine the level of economic rent from roundwood production and to comment on the forest revenue system in the country. The results and analysis presented here are based on information collected during a two-week mission to Fiji (from 14-24 October 2003), along with additional information collected from FAO databases and other international sources.

The paper was prepared in response to a request from the Government of Fiji to FAO, for assistance with reviewing the forest revenue system in the country. The requirement for this work arose out of the recommendations of a 1989 study of the forestry sector in Fiji. The analysis here addresses three issues raised in that study, namely: the forest revenue system in Fiji; taxation of the forest industry; and the costs and benefits of the forest industry to the national economy.

Analytical framework

The analysis of the forest revenue system has been based on the theory of “economic rent”. In the forestry context, economic rent is the value of forest productivity, which can be determined by subtracting all of the costs of production and processing from the final value of outputs sold in the market place. This is often referred to as the “residual stumpage value” methodology and is a standard methodology used in many countries around the World to estimate the value of standing trees.

Production and processing costs have been calculated from the costs of labour, raw materials and capital used in forest industry operations, using standard economic and accounting methodologies. In addition, economic rent calculations recognise the necessity for forest operators to earn a reasonable rate of return on the capital employed in their operations (i.e. a return on capital or ROC). This rate of return, sometimes referred to as “normal profit”, has been set at a level of 20 percent, which seems reasonable in view of the other investment opportunities available in Fiji, the risk associated with forest operations and the expectations of those involved in the industry.1

In theory, the economic rent from forest operations should accrue to the owners of the forest resource. Therefore, in the case of Fiji, the majority of this should accrue to landowners. However, as the Government is responsible for revenue collection and disbursement, a small share should also accrue to the Government to cover their administration costs.

If the sum of all forest charges is less than the economic rent, then the remaining amount accrues to forest operators and is usually referred to as “excess profit” or “windfall profit” (i.e. an amount over and above the “normal profit” required to remain in business). The aim of the forest revenue system should be to ensure that landowners receive the maximum benefit possible from the use of their resource and to minimise any “excess profit” earned by the industry.

Data collection and analysis

The economics of forest harvesting and processing was analysed using two models:

• The forest harvesting cost model calculates the cost of forest harvesting, extraction and delivery to the mill, from the costs of labour, consumables and capital (including ROC) employed in forest operations. The model is based on standard cost accounting methodologies as described in FAO (1977). The model was originally constructed to analyse the costs of forest operations in Suriname, but it has been modified to reflect harvesting costs, productivity and site conditions prevalent in Fiji.

• The forest industry model calculates the profitability of forest processing operations in a similar way to above, with the exception that it uses projected cash-flows from the operation to calculate profitability (i.e. net present value or NPV). This model was originally constructed to analyse the profitability of forest processing operations in Indonesia, but it has also been adjusted to reflect the scale of operations, productivity levels and costs in the industry in Fiji. For the purposes of this analysis, the model examines the situation of a medium-sized sawmill in the country.

The cost information produced from the forest harvesting cost model is used as an input to the forest industry model. These costs, plus other operational costs (including forest charges), are then used in the forest industry model to estimate net income, by subtracting the total of these costs from the value of output (i.e. forest product prices multiplied by production volumes). Annual net income from processing operations is included in the projected cash-flow, along with the cost of capital investments (i.e. plant and machinery).

The cash-flow from operations is discounted (at the required ROC) to produce the NPV of the sawmill investment, which is equal to the “excess profit” from operations. The forest industry model estimates the share of the economic rent that is currently captured by the Government and landowners in the form of forest charges. It also estimates the amounts that should be paid as corporate taxes by forest operators.

Data for all of these models has been collected from three main sources:

• Baseline estimates of unit costs, prices, consumption of materials and productivity rates has been taken from information published by the Forestry Department and other international data sources.

• Where necessary, these costs have then been adjusted to reflect local conditions, based on discussions with representatives of the industry and government in Fiji.

• Further adjustments were also made as a result of site visits to and discussions with a number of forest operators on Viti Levu and Vanua Levu.

It should be noted that there will always be some uncertainty with the results of any economic rent analysis. Firstly, it is often difficult to obtain reliable and accurate cost and price information. Forest operators have an incentive to exaggerate costs and understate the value of production. Secondly, in some cases, forest operators may not themselves have a reliable view of their costs. Thirdly, there are often problems regarding the level of efficiency in the industry. It is quite common for economic rent to be dissipated through inefficient operations, so it is not always the case that surplus economic rent (i.e. the share of economic rent that is not captured by government and landowners) accrues to the forest operator as excess profit. Finally, it should be noted that economic rent calculations are often based on industry averages. Some operators will be more or less efficient than others, some will be better or worse at marketing their product and some will benefit (or suffer from higher production costs) due to factors such as the scale of operations, site conditions and location. Thus, the results of this analysis should only be used as a general guide to the level of charges that might be collected.

In most tropical countries, the charges for harvesting roundwood are determined in one of two ways:

• In some counties, tropical forest resources are owned by the state and the state sets royalty rates and collects charges, which then become part of the government’s revenue collection.

• In other countries, landowners own forest resources and are free to set their own charges in negotiation with forest operators, which they then keep themselves.

In both of the above situations, the two main issues of concern in any analysis of forest charges are the levels of charges that are set (i.e. how much of the economic rent is captured by the resource owners' forest charges) and the distribution of charges (i.e. how much of the charges collected should go to the Government and how much should be retained by people living in and around forest areas)

The system of forest charges that has developed in Fiji is somewhat unusual in that the government sets and collects royalties (that are then distributed to landowners) but, on top of this, landowners have also started to collect their own additional charges (“commissions” and payments for “goodwill”). In other words, the total level of charges that is eventually set is determined largely by negotiation between landowners and forest operators (i.e. they negotiate the surplus in addition to the royalty payments). A summary of all of the forest charges currently collected in Fiji is given in Table 1.

Table 1 Summary of forest charges in Fiji in 2003

Type of charge

Amount by species class (in FJD per m3)

Class 1

Class 2

Class 3

Class 4

Royalty

Zone 1 (Viti Levu)

40.00

30.00

10.00

6.50

Zone 2 (Vanua Levu)

40.00

30.00

9.30

6.00

Zone 3 (elsewhere)

32.00

32.00

8.00

6.00

Premium

Zone 1 (Viti Levu)

4.00 - 6.00

Zone 2 (Vanua Levu)

nil

Zone 3 (elsewhere)

nil

Commission

Zone 1 (Viti Levu)

20.00 - 45.00

10.00 - 20.00

10.00 - 15.00

10.00 - 12.00

Zone 2 (Vanua Levu)

15.00 - 25.00

10.00 - 15.00

10.00 - 15.00

10.00 - 12.00

Zone 3 (elsewhere)

data not available

Goodwill

0.50-12.00

Land Rent

varies

Scaling Fee

3.50

Map Fee

varies (charged on the basis of cost recovery)

Application Fee

varies (charged on the basis of cost recovery)

Renewal Fee

varies (charged on the basis of cost recovery)

Processing Fee

varies (charged on the basis of cost recovery)

Source: various documents, interviews and field visits.

Although nearly all of the charges collected are distributed to the landowners, the government retains a small proportion of the total charges collected, to cover their administrative costs (i.e. the “fees” at the bottom of the table). It should also be noted that the distribution (amongst landowners) of the charges collected may differ between the official charges collected as royalties and the additional charges collected directly by landowners.

Comparing the historical trends in forest charges (over the last two decades) with inflation and changes in sawnwood prices, Royalties have increased broadly in line with inflation in the three lowest species classes. Royalties for Class 1 species have increased by 25 percent in real terms, which roughly matches the increase in average sawnwood export prices. It should also be noted that payment of the informal charges directly to landowners is a fairly recent innovation, which was started by forest processors. These developments suggest that there is a lot of competition for access to the resource and that forest charges have responded to changes in product prices and resource availability.

Results of the economic rent analysis

Economic rent has been calculated for a “typical” forest operation in Fiji. In the forest harvesting operation, it has been assumed that the operator is harvesting 200 ha per year, at an average harvesting intensity of 30 m3/ha, to give an average level of production of 3,000 m3/year. It has been assumed that the forest operator has to construct 20 metres of road per ha (including an access road) and has a haulage distance of 50 km (each way). At this level of production and working for 8 months per year (with an 8-hour day), the operator could harvest, extract, load and unload and transport the total volume of roundwood production with one chainsaw crew, one D6 bulldozer (for road building and skidding), one loader and one truck (with a 25 m3 capacity). It has also been assumed that the average age of the truck is 7 years old, while the average age of the other equipment is 18 years old. The depreciated value of these items has been calculated and used in the economic rent calculations.

Under the above assumptions, the total delivered cost of roundwood production would be around FJD 64/m3. This is quite reasonable in comparison with production costs in other tropical countries. Figure 22 shows the composition of this cost by production activity and type of cost. Changes in transport distance would change production costs slightly, at a rate of roughly FJD 0.17/m3 per kilometre. Lower harvesting intensities could increase production costs significantly, but this would depend upon how much road building would be required in forests with lower stocking.

Figure 1 Total delivered roundwood production cost in Fiji (by activity and type of cost)

For the analysis of forest processing costs, the following assumptions have been made about the status and condition of an “average” sawmill in Fiji:

• output capacity of 5,000 m3/year, with a current level of capacity utilisation of 60 percent, giving a current output level of about 3,000 m3/year;

• average product recovery rate of 50 percent across all product types, giving a required log input of 6,000 m3/year;

• sawnwood production of a range of grades, with 50 percent for export and 50 percent for the domestic market, with most of the Class 1 and 2 species going into the export market; and

• a debt-equity ratio of 20:80, with debt financed at a real interest rate of 12 percent.

Total fixed and variable operating costs used in the model are presented in Table 2 below. The log cost in this table includes the delivered roundwood production cost and the payment of all forest charges (as shown in Table 1 above) across the range of species used in the sawmill (see Table 3 for details of the assumed species composition of production).

Table 2 Fixed and variable operating costs for an “average” sawmill in Fiji

Variable costs (FJD per m3 of production)

Sawnwood for

export market

Sawnwood for

domestic market

Log cost

275.94

225.54

Labour

78.96

78.96

Resins/chemicals/treatment

15.00

15.00

Fuel, energy and consumables

60.00

45.00

Packaging

32.00

6.00

Delivery

15.00

15.00

Total

476.90

385.50

Fixed costs (FJD per m3 of capacity)

Personnel: administration

12.00

12.00

Personnel: support staff

7.00

7.00

Personnel: maintenance staff

9.73

9.73

Sales cost

15.00

15.00

General overhead

30.00

30.00

Total

73.73

73.73

Total cost (FJD per m3 of production)

Total calculated at final level of utilisation

599.79

508.39

For the capital cost of the sawmill, it has been assumed that the depreciated value of all plant and machinery is about FJD 1.4 million, with a further FJD 573,000 invested in working capital, giving a total investment of around FJD 2.0 million. The depreciation period used is five years and various assumptions were also made about the replacement or overhauling of some capital items after three to five years.

The composition of sawnwood production (by species class and grade) assumed in the model and the selling prices of each of the different products are shown in Table 3. The average selling price is FJD 763/m3, which is in the region of the average product prices revealed in discussions with sawmillers.

Table 3 Product sales by market and grade of production for an “average” sawmill in Fiji

Product

Grade

Export tax

(percent)

Output

(percent)

Mill net price

(FJD per m3)

Real price change

(percent/year)

Sawnwood for export market

Class 1

FF Select

0

50.0

1,200

0.0

Class 1

FF Standard

0

7.5

900

0.0

Class 1

Ungraded

0

2.5

900

0.0

Class 2

FF Select

0

30.0

800

0.0

Class 2

FF Standard

0

7.5

800

0.0

Class 2

Ungraded

0

2.5

750

0.0

Total/average

100

1,009

0.0

Sawnwood for domestic market

Class 1

FF Select

0

15.0

750

0.0

Class 1

FF Standard

0

5.0

550

0.0

Class 2

FF Select

0

5.0

580

0.0

Class 2

FF Standard

0

5.0

480

0.0

Class 3

FF Select

0

35.0

480

0.0

Class 3

FF Standard

0

12.0

480

0.0

Class 4

FF Select

0

15.0

480

0.0

Class 4

FF Standard

0

3.0

480

0.0

Class 3 and 4

Ungraded

0

5.0

250

0.0

Total/average

100

518

0.0

Given the above costs and prices, the composition of sawnwood production costs for the “average” sawmill in Fiji was calculated and is shown in Box 1 below. The delivered roundwood cost includes an allowance for “normal profit” in the harvesting operation, but excludes the payment of forest charges. Forest charges include the payment of all official and unofficial charges (i.e. “goodwill” and “commissions”). Capital costs represents the consumption of existing and replacement capital throughout the life of the sawmill investment (assuming zero residual value), while “normal profit” represents the amount required for the sawmill operator to earn a 20 percent ROC (after tax) on their equity investment in the sawmill. Corporation tax is the estimated average annual tax liability divided by annual sawnwood production.

Box 1 Composition of sawnwood production costs for an “average” sawmill in Fiji

The economic rent from production is equal to forest charges plus “excess profit” and amounts to FJD 128.54 per cubic metre of sawnwood produced, or about 17 percent of the average product value. With the assumed product recovery rate of 50 percent, this implies that the economic rent is equal to FJD 64.27 per cubic metre of roundwood consumed by the sawmill. As these figures show, under the above assumptions, the majority of the economic rent from production is captured by the existing forest charges. Given the variability in costs and prices that probably exists across the sector and the fact that these are calculations based on averages, these figures suggest that there is little room to increase forest charges.

Figure 2 Distribution of the economic rent from production in Fiji between landowners, government and industry per cubic metre of roundwood (CUM)

Figure 2 shows the distribution of economic rent from production (per cubic metre of roundwood) between landowners, the Government and industry. The figure shows that total forest charges currently capture 95 percent or almost all of the economic rent from production. Fees paid to the Forestry Department and NLTB each account for a further 5 percent of the economic rent. Landowners receive the remaining 85 percent of the economic rent. Of this, slightly more than half of this comes through the official system of royalty payments as opposed to the unofficial system of “commissions” and payments for “goodwill”.

It should also be noted that, in addition to the payments of charges to the Government, the “average” sawmill should be paying corporation taxes to the Government of around FJD 35.25 per cubic metre of sawnwood produced (equal to about FJD 17.63 per cubic metre of roundwood).

The results above have been compared with the figures quoted in the submission on forest charges from the Fiji Sawmillers Association (FSA, 2003). Although there are some differences between these results and the figures from the FSA, the overall results are broadly comparable. For example, they quote figures for total sawnwood production costs (excluding a profit margin) in the range of FJD 570/m3 to FJD 720/m3. The figure calculated here for total operational costs plus capital costs amounts to FJD 640/m3 (see Box 1), which is roughly in the middle of this range.

It should be noted that the above results are not simply a reiteration of the FSA figures, having been based on data collected from a number of sources in Fiji and elsewhere and having been calculated in an entirely different way. Indeed, the purpose of this analysis was to bring some international experience and a rigorous analytical approach to the forest charging issue, in order to provide the Forestry Department with an independent estimate of the economic rent from production. As the figures calculated here are not markedly different from those provided by the FSA, it is suggested that this might be taken as an indicator of their reliability.

Further analysis has examined the variation in economic rent between the different species classes. Based on the price data shown in Table 3, this has shown that there could be much wider variation in the economic rent from different species than is currently reflected in the forest charges. However, it is felt that the reliability of the price data is currently insufficient to support a radical revision to the relative levels of the forest charges for different species classes. A relatively simple methodology has been presented to allow this to be explored further.

Conclusions and recommendations

On the whole, the procedures currently in place for monitoring production and collecting forest charges are excellent. However, it is debatable whether the Government recovers all of their administrative costs of implementing the system. There is also some uncertainty about whether the current licensing arrangements provide landowners and producers with a secure and binding agreement to supply roundwood and pay all unofficial charges.

• Recommendation 1: Administrative costs. The Forestry Department should review their expenditure on forest monitoring, control and charge collection to assess whether their fees cover their costs. If not, they should consider increasing their fees. There is very little room for an increase in charges, but a modest increase in the Scaling Fee would probably do no harm. NLTB may wish to consider this issue as well.

• Recommendation 2: Licences and security of wood supply. In consultation with interested stakeholders, the Forestry Department and NLTB should examine whether the problem of landowners and/or producers reneging on production agreements is a major problem and what, if anything, they should do about it. The aim should be to use licences to reinforce the agreement to supply roundwood in a harvesting area, to minimise the likelihood of broken contracts and the consequential costs to both landowners and producers.

Currently, the sum of official and unofficial forest charges appears to account for the majority of the economic rent from production, suggesting that there is little scope to increase charges overall. However, the amounts collected in the form of unofficial charges are not recorded anywhere and can not be accurately judged. It would be in everyone’s interest if this information was recorded properly and published.

• Recommendation 3: Total charge collection. The Forestry Department should record the total amount of revenue collected from unofficial charges and publish this information along with the statistics on official revenue collection. The level of unofficial payments (lump-sums and per cubic metre) should be recorded in licence agreements.

The current system whereby forest charges are set by a mixture of administrative decree (official charges) and negotiation (unofficial charges) has distinct advantages in terms of promoting economic efficiency. This is because there appears to be a high level of competition for the resource. Therefore, there is little economic justification to increase the overall level of forest Royalties. However, the relative levels of the Royalties for different species classes is worthy of further examination, as well as the composition of the species classes. A modest increase in the level of Royalties for the higher valued species could be partly offset by reductions in Royalties for the lower valued species classes. Improvements in the availability of information about the levels of (unofficial and official) charges currently being paid would also assist landowners and producers in their negotiations.

• Recommendation 4: Analyse the relative values of different species. The Forestry Department should collect some better information about product prices (in domestic and export markets) and the mixture of products typically produced from each species (by grade and market destination). This should be analysed to identify the relative levels of economic rent from different species and revise the composition of the species classes.

• Recommendation 5: Revision of the Royalties. Royalties should not be increased by very much (if at all). For example, Royalties in the top two species classes could be increased in line with inflation and Royalties in the lower two species classes could be kept the same or even reduced. The relative levels of the different species classes (and movement of individual species between the classes) should be determined from the outcome of Recommendation 3,

• Recommendation 6: Average levels of unofficial charges. The Forestry Department should publish annually the average level of unofficial charges paid by producers (per cubic metre) by species class and zone.

Competition requires a “level playing field” and the Forestry Department should not restrict the awarding of licences to specific groups or individuals. However, they should also ensure that all operators are competent and able to follow the same requirements for good harvesting practice. The frequent use of short-term Annual Licences and the fragmented nature of forest ownership are a barrier to the long-term development of the sector, which will require security of supplies and economies of scale. The Forestry Department might examine how they can encourage improved performance in the processing sector through the types of licences available to producers and by increasing the scale and security of wood supply.

• Recommendation 7: Awarding licenses. Licences should continue to be awarded in an open and transparent manner without fear or favour, subject to the condition that all producers have to meet the same minimum standards of competence and comply with all forest regulations.

• Recommendation 8: Long-term strategy. The Forestry Department should consult with all interested stakeholders about the feasibility of developing a long-term strategy for the sector. In particular, this should focus on improving the security of wood supply from the highly fragmented forest ownership, while maintaining the overall objective that landowners should continue to receive the maximum possible benefit from the use of their forest resources.

The question of how much of the forest charges should go through official channels and how much should go through unofficial channels is a sensitive issue. Ultimately, the decision about this should be a political decision, which is beyond the scope of this report. An impartial economic appraisal of the situation could conclude that, if landowners are capable of looking after their own interests, then there is no need for the NLTB to collect forest charges at all. However, the current system whereby NLTB are involved has two advantages:

• it provides a more formal and accountable system to ensure that everyone that is entitled to a share of the benefits from production is given a share; and

• it provides a safety-net to ensure that landowners receive the maximum possible amount of benefits from the utilisation of their resource.

Evidence from other countries that have given landowners more control over forest charges has shown that that they sometimes lose out in the long run. Therefore, this would support the argument that NLTB should continue to be involved in the administration of the forest revenue system.

• Recommendation 9: Revenue collection and disbursement. NLTB should continue to play a role in revenue collection and disbursement in order to provide a safety-net for landowners.

1 Note: a 20 percent ROC s not the same as a 20 percent profit margin (see Section 5.2 on page 42 for further explanation of the calculation methodology employed here).

2 The term “forest charges” is used here to cover all payments made to government and landowners by forest operators, including royalties, fees and other payments made to landowners.